The $5 trillion bailout

The US government has finally decided to nationalise the two home loan giants, Fannie Mae and Freddie Mac. Readers will remember I forecast this would be necessary a year ago, in a letter to the Financial Times. I argued then that ‘a buyer of last resort, such as the Federal government, would probably now need to emerge, if the situation is to be stabilised’.
Fannie and Freddie guarantee 47% of all US mortgages, worth over $5 trillion – equal to the combined GDP of the UK and France. According to the excellent Gretchen Morgensen in today’s New York Times, today’s move ‘grew out of deep concern among foreign investors that the companies’ debt might not be repaid’, with China owed at least $340bn.
As the blog noted in July, this vast debt was supported by just $70bn of capital. And Morgensen reveals today that even this number is probably overstated. As I discuss below, high leverage makes earnings (and management) look wonderful whilst things are going well. But it also, as we now see with Fannie/Freddie, makes bankruptcy much more likely in the down cycle.

2 thoughts on “The $5 trillion bailout”

  1. John Blackthorne

    Where in the letter did you say it was necessary to nationalise Fannie Mae and Freddy Mac?
    I didn’t see those four words being mentioned in your letter to the FT.

  2. Many thanks for the comment.
    The context is that the actual FT debate and recent editorial at the end of August 2007 on which I was commenting was about Fannie and Freddie – here is the text of the Obama story, for example:
    “Obama unveils radical mortgage plan
    By Jeremy Grant and Eoin Callan in Washington
    Published: August 29 2007 03:00 | Last updated: August 29 2007 03:00
    Unscrupulous lenders who deceptively sold subprime mortgages to millions of Americans should be fined and the proceeds used to help bail out borrowers facing a wave of foreclosures, according to Barack Obama, the Democratic senator running to be his party’s presidential candidate.
    The proposal is among the most radical yet from a leading Democrat and comes as Washington tries to respond to a growing wave of foreclosures and a crisis in credit markets.
    It also comes amid greater discussion in Washingtonon whether the mortgage industry – including credit rating agencies involvedin rating mortgage-related securities – should be more tightly regulated to prevent a repeat of the crisis.
    Writing in today’s Financial Times, Mr Obama blamed lobbyists working on behalf of lenders for obstructing tougher regulation of the subprime industry, adding: “Our government failed to provide the regulatory scrutiny that could have prevented this crisis.
    “While predatory lenders were driving low-income families into financial ruin, 10 of the country’s largest mortgage lenders were spending more than $185m (€136m, £92m) lobbying Washington to let them get away with it,” he wrote, citing figures from the Centre for Responsive Politics.
    Wall Street banks have also stepped up their lobbying over the issue of subprime lending as their underwriting practices come under scrutiny. It emerged this week that Citigroup paid $160,000 in the first half of this year for lobbying services from Ogilvy Government Relations.
    Mr Obama said the government needed to “stop the unlicensed, unregulated, fly-by-night mortgage brokers who are hoodwinking low-income borrowers into loans they can’t afford”.
    He added that “Washington needs to stop acting like an industry advocate and start acting like a public advocate”.
    Curtailing undue corporate influence on policymaking in Washington is one of Mr Obama’s signature issues.
    Mr Obama’s proposal is one of many to have emerged in recent weeks from Democrats as they seek to take advantage of what they see as a potential weakness in the Bush administration’s response to the subprime crisis.
    Christopher Dodd, Senate banking committee chairman, and Barney Frank, who heads the House financial services committee, have called on the administration to allow giant mortgage lenders Fannie Mae and Freddie Mac to step in by lifting caps on their mortgage portfolios.
    The administration op-poses such a move, arguing Congress must first pass pending legislation reforming how they are overseen. It favours less radical steps such as expanding a loan insurance scheme operated for decades by the Federal Housing Administration.
    Ethan Harris, an economist at Lehman Brothers, said: “There needs to be rationalisation – more centralisation – of how mortgage lending is regulated.”
    You’ll see the foucs was on comments by people such as Christopher Dodd about the role of Fannie and Freddie, and I wanted to make the point that the problem was far larger than they had realised – hence the final two paragraphs of my letter were referring to this as follows:
    “The problem is that the whole story turns out to have been an illusion. The S&P/Case-Schiller US home price index is firmly in negative territory, while the number of unsold houses is climbing. A “buyer of last resort”, such as the Federal government, would probably now need to emerge if the situation is to be stabilised.
    Even Congress would surely balk at the amount of money that this scale of intervention would require. Unfortunately, therefore, the myth behind the US housing mania is likely to become increasingly transparent, as the fallout from it widens.”
    Given that the letter was written on 7 September 2007, I think it pretty much forecast the way the sitution developed subsequently. The Federal government did have to emerge as the ‘buyer of last resort’ – de facto nationalisation – and Congress did initially balk at the moment of money that was (and will continue to be) required.

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